Executive summary
There are several factors that are generally considered in the starting of a business. These factors include availability of capital, skills available, location of the business among others. In an advanced level, one should also consider the tax implications of starting each particular business.
There are several forms of business formations. Depending on the owner’s preference, one may decide to start a sole proprietors business, a partnership or incorporate a company. This study will majorly discuss the modes of formation of a sole proprietorship and a company, the advantages of running these types of business and the suitability of such businesses at different levels of revenue. We shall however dwell on the in depth analysis of the after tax returns to the owners of the business for each form of business formation.
Sole proprietorship
Formation
This is the simplest form of business formation. This business is owned and run by a single owner although he may enlist the assistance of family members. There are several advantages to the formation of this business as explained below.
Small amount of capital is required at the start up stage. Since only one person runs this form of business, capital may not be a major set back
Decision making is quite fast since only one individual is involved unlike a corporation or partnership where wide consultations may be required to approve any decision.
In a sole proprietorship, the owner gets all the profits unlike in companies or partnerships where the profit is shared amongst the owners.
It’s very easy to form a proprietorship business since very few formalities and legal requirements are necessary in the formation of this business.
There are several shortcomings that rock this form of business.
Any losses that may arise in the course of business are borne by only one person, the owner.
Bad decisions are likely to be made since the owner makes them solely without much consultation
There is overburdening the owner with too much work since he has to do virtually everything on his own.
It is not very easy to raise capital for a sole proprietor since he may not have enough collateral to secure loans from financial institutions limiting his scope of expansion.
Company
This is probably the most complex business formation. There are several requirements for a company to be incorporated. After the members have agreed to form the company, they must agree on the major business objective which is included in the memorandum of association, one of the documents required by the company registrars for the formation of the business.
After the owners have raised the required capital, they must submit the following documents to the registrar before the company is incorporated:
Memorandum of association
This document defines the relationship between the business and outsiders. It contains the following clauses.
Name- this gives the desired name of the company as intended by the owners
Location clause- this clause indicates the physical address of the company, usually the head office of the business.
Capital- this indicates the authorized capital for the company; this capital must be raised before the company is incorporated.
Liability- this clause mentions whether the company is a limited company or not and its limited, whether its limited by guarantee or by shares. Just to mention a few.
Article of association
This is the internal constitution in the business and it governs the internal affairs of the business. All issues pertaining the management and members rights and obligations, appointment, dismissal and terms of directorship are discussed in this document. Rules relating to dividends are also available in this document.
Declaration by members- this document simply confirms that the members have agreed to form the said business.
Declaration by directors- here the directors confirm their acceptance to act as directors of the company.
After the promoters of the company present the above documents to the register of the company, a certificate of incorporation is issued. For public companies though, a certificate of trade is required for them to commence business.
Despite the above formalities and other legal requirements, companies have very many advantages compared to other forms of business formations. These are explained below:
Limited liability - the liability of a company is limited to the capital contributed and personal property cannot be attached incase of insolvency.
Ability to raise capital- due to the large collateral that may be available to the company besides the owners contributions, companies are able to get financing from financial institutions.
Professional management- due to the nature of the business and the legal entity status, the business is run separately from family and domestic issues in amore professional way.
Other advantages that relate to this form of business include the benefits of incorporation which include: the ability to own property in its own name, ability to sue and be sued among other factors arising from the separate legal entity status.
After an analysis of the theoretical issues governing these forms of businesses, we shall now evaluate the suitableness of each of these business formations from the benefits that accrue to the owners of the business after federal taxes have been deducted, beginning from given revenue levels.
We shall begin our analysis with the sole proprietor.
Sole proprietorship
Revenue 30000
Expenses
Salaries and wages 18000
Electricity 1000
Rent and rates 2000
Licenses 500
Postages 1000
Miscellaneous expenses 200 22700
Net profit before tax 7300
Tax computation for the entity
Assuming a single individual is involved in this business, the following taxes will apply.
0-8375 USD……………………………………10%
8376-34000 USD………………………………15%
34000-82400 usd………………………………..25%
82401-171850…………………………………28%
171854-373650…………………………………33%
373651+…………………………………………35%
Since in a sole proprietorship the owner gets all the profits, the profit becomes the income of the owner and it’s thus taxed on him at the graduated scale rates as follows;
The income lies in the bracket of 0-8375 so it’s taxed at the rate of 10% leaving the owner of the business with 7300-(10%*7300) = 6570.
YEAR II
At a revenue level of 60,000, the analysis will be as follows.
Revenue 60000
Salaries and wages 36000
Electricity 3000
Rent and rates 3000
Licenses 2000
Postages 1000
Miscellaneous 400 45400
Net profit before tax 14600
The money that remains after tax will be computed as:
8375*10% = 837.5
(14600-8375) 0.15 = 879.75
Profit after tax = 14600-(837.5+879.75) = 12882.75
Year III
At a revenue level of 180,000, the tax computation will be analyzed as follows,
Revenue 180000
Expenses
Salaries and wages 108000
Electricity 8000
Rent and rates 10000
Licenses 2200
Postages 4000
Miscellaneous 4000 151800
Net profit before tax 28200
The net profit after tax is computed as follows;
8375*10% = 873.5
(28200-8375)*15% = 2973.75
Profit after tax = 28200-(873.5+2973.75) = 24352.75
Year IV
At a revenue level of 375000, the after tax profit can be computed as follows;
Revenue 375000
Expenses
Salaries and wages 225000
Electricity 20000
Rent 20000
Postages 3000
Licenses 5875
Miscellaneous 10000 283875
Net profit before tax 91125
The after tax net profit to the owner is computed as follows
8375*10% = 837.5
34000*15% = 5100
48750*25% = 12187.5
Profit after tax = 91125-(837.5+5100+12187.5) = 73000
Year V
Starting with revenue of 650,000 the analysis will be as follows
Revenue 650000
Expenses
Salaries and wages 390000
Rent and rates 30000
Electricity 35000
License 20000
Postages 6833
Miscellaneous expenses 10000 491833
Net profit before tax 158167
After tax profit retained is calculated as follows;
8375*10% = 873.5
34000*15% = 5100
82400*25% = 20600
33392*28% = 9349.76
Net profit after tax = 158167-(873.5+5100+20600+9349.79) = 122243.74
The owner of the business is left with the after tax net profit as the net income since he gets all the profits. In the case of company the analysis is different in the following way;
The owners of the business are a paid fee that is tax deductible when computing tax liability.
The corporate tax rate is a flat rate of 35%
The expenses in a company are slightly different from those of the sole proprietorship as shown by the illustrations below.
Year I
Beginning with a revenue level of 30,000, the analysis will be:
Revenue 30000
Expenses
Salaries and wages 10000
Directors fees 2000
Loan interests 1000
Rent and rates 2000
Electricity 5000
Commissions 2200
Miscellaneous expenses 500 22700
Net profit before tax 7300
Tax will be computed as 35%*7300 = 2555
The value available to the owners of the business will be 7300-2555=4745
Year II
With a revenue level of 60,000, the tax analysis will be as follows
Revenue 60000
Expenses
Salaries and wages 30000
Director’s fees 3000
Electricity 6000
Rent and rates 4200
Commissions 1200
Miscellaneous expenses 1000 45400 14600
After tax net profit is computed as 14600-(35%*14600) = 9490
Year III
Computation
Revenue 180000
Expenses
Salaries and wages 108000
Directors fees 5800
Rent and rates 16000
Electricity 13000
Commissions 7000
Miscellaneous expenses 2000 151800
Net profit before tax 28200
Profit after tax=28200-(0.35*28200) = 18330
Year IV
Computation
Revenue 375000
Expenses
Salaries and wages 210000
Directors’ fees 15375
Rent and rates 15000
Electricity 10000
Commissions 8500
Miscellaneous expenses 5000 283875
Profit before tax 91125
Net profit after tax 91125-(35%*91125) = 59231.25
Year V
Revenue 650000
Expenses
Salaries and wages 400000
Directors fees 15000
Commissions 15833
Rent and rates 25000
Miscellaneous expenses 8000
Electricity 18000 491833
Profit before tax 158167
Tax computation is as follows 158167-(35%*158167) = 102808
From the analysis above, it’s evident that corporations bear a larger amount of tax compared to the sole proprietorship business. At the various revenue levels, the corporation pays a large amount of tax compared to the sole proprietor. This issue can also be viewed from the fact that the owners of the business are already paid in the corporations in the form of directors fees.
Whilst the sole proprietor is charged final tax at the graduated scale rates indicated above, the owners of the company are charged double tax, at the corporation level and at personal level. The amount they earn as directors fees is still subject to the prevailing income tax rates.
In my opinion, its preferable to run a sole proprietorship business since at all levels of income, the after tax profit is more than the one for an incorporated company at the same pre tax profit.
References
Brumbaugh, David L. Esenwein, Gregg A., Gravelle, Jane G., “Overview of the Federal Tax System,” Congressional Research Service Report for Congress, updated June 2, 2006
Hart, Phil, Constitutional Income: Do You Have Any?, 3rd edition, (Alpine Press, 2005)
Johnson, Calvin H. “Fixing the Constitutional Absurdity of the Apportionment of Direct Tax,” Constitutional Commentary, Volume 21 No. 2 (June 2004), p. 295
Becraft, Larry. Uncertainty of the Federal Income Tax Laws, (Sept. 1, 1999),
Thorndike, Joe, “An Army of Officials: The Civil War Bureau of Internal Revenue,” Tax History Project, Dec. 21, 2001.
Skinner, Otto. The Biggest “Tax Loophole” of All, (San Pedro: Otto U. Skinner, 1997)
Stratton, Lawrence M. Jr. and Moore, Stephen and Roberts, Paul Craig, “The Roots of the Income Tax,” National Review, April 17, 1995
